Saturday, 25 April 2015

Why export quotas probably failed to help coffee farmers

Last year, my wife and I both read the same story from Daily Coffee News, entitled "A Brief History of Coffee Price Volatility in the Modern Era (1963-2013)". Probably unsurprisingly given our different disciplinary backgrounds, we had completely different takeaways from the story. On the one hand, you could take away that free market forces are a bad thing, because they led to volatility in the price of coffee on world markets - as the International Coffee Organization is quoted in the article as saying, this "makes it difficult for roasters to control processing costs and affects profit margins for traders and stockholders, making their activities less attractive".

What I took away from the article was how the International Coffee Organization ensured price stability in the period from 1963 to 1989 - by using a system of export quotas in producing countries. My overall comment was "wow, the coffee farmers were probably worse off, but I bet the middlemen were happy". And now I'll explain why (which I've been promising my wife I would do here for some time).

Let's start with an exporting country - a country that has a comparative advantage producing the product (coffee in this case). That means that the country can produce coffee at a lower opportunity cost than other countries. On a supply-and-demand diagram like the one below, it means that the domestic market equilibrium price of coffee (PD) would be below the price of coffee on the world market (PW). Because the domestic price is lower than the world price, if the country is open to trade there are opportunities for traders to buy coffee in the domestic market (at the price PD), and sell it on the world market (at the price PW) and make a profit (or maybe the suppliers themselves sell directly to the world market for the price PW). In other words, there are incentives to export coffee. The domestic consumers would end up having to pay the price PW for coffee as well, since they would be competing with the world price (and who would sell at the lower price PD when they could sell on the world market for PW instead?). At this higher price, the domestic consumers choose to purchase Qd0 coffee, while the domestic suppliers sell Qs0 coffee (assuming that the world market could absorb any quantity of coffee that was produced). The difference (Qs0 - Qd0) is the quantity of coffee that is exported. Essentially the demand curve with exports follows the red line in the diagram.

We can also use the diagram to demonstrate the gains from trade for an exporting country. Without trade, the market would operate at the domestic equilibrium, with price PD and quantity Q0. Consumer surplus (the gains to domestic coffee consumers) would be the area AEPD, the producer surplus (the gains to domestic coffee producers) would be the area PDEF, and total welfare (the sum of consumer surplus and producer surplus, or the gains to society overall) would be the area AEF. With trade, the consumer surplus decreases to ABPW, the producer surplus increases to PWCF, and total welfare increases to ABCF. Since total welfare is larger (by the area BCE), this represents the gains from trade. So, coffee farmers are better off with trade, because the producer surplus is larger than it is without trade.

What happens when there is an export quota? This is demonstrated in the diagram below. Whereas previously, we assumed that the world market could absorb any quantity of exports of coffee, now the quantity of exports is limited to the agreed quota amount. Let's say that the export quota is limited to the amount between B and G (about half the amount of unrestricted exports). Importantly, the export quota is implemented using licenses - only holders of export licenses are allowed to export.

Now that there is a quota on exports, consider what happens to the demand curve (including exports). The upper part represents the domestic consumers with high willingness-to-pay for coffee. Then there is a limited quantity of export demand, at the world price PW. After that, there are still profit opportunities for domestic suppliers (that is, there are still some domestic consumers who are willing to pay more than what it costs the suppliers to produce coffee). So, the demand curve (including the export quota) pivots at the point G, and follows a parallel path to the original demand curve (i.e. the demand curve including exports follows the red line in the diagram). The domestic price is the price where supply is equal to demand (P1). Export license holders can purchase coffee at this price, and then sell it on the world market and receive the higher world price (PW), and pocket a profit. The domestic consumers choose to purchase Qd1 coffee at the price P1, while the domestic suppliers sell Qs1 coffee at that price. The difference (Qs1 - Qd1) is the quantity of exports (which is also the quantity of the quota).

Now the consumer surplus is larger than it was without the export quota (it is now the area AJP1), the producer surplus is smaller than it was without the export quota (it is now the area P1HF). The export license holders now receive a surplus (profit), equal to the area KLHJ. Total welfare (which is now made up of the consumer surplus, producer surplus, and license holder surplus) is smaller than without the export quota (it is now the area AJHF+KLHJ). There is a deadweight loss (a loss of total welfare arising from the export quota) equal to the area [BKJ + LCH] - these areas were part of total welfare with trade and no export quota, but have now been lost.

Of most interest to us though is that the export quotas don't help the coffee farmers - producer surplus has fallen. In contrast, the export license holders (the middle men, who buy coffee from the farmers and sell it on the world market) are made better off by the export quota system.

But wait - what if the export quota system makes world coffee prices higher? That seems a reasonable possibility - if all coffee producing countries are restricting the supply of coffee to the world market, then that should raise prices for all. I'm sure that's what the International Coffee Organization was probably trying to do all along.

The diagram below demonstrates what happens, if the quota is kept the same size as the previous diagram, but the world price increases from PW to PX. The demand curve (including the export quota) now follows the purple path (since the license holders can now sell at the higher price PX instead of PW), but notice that the resulting domestic price is exactly the same (P1). In terms of welfare effects, the resulting consumer surplus and producer surplus are unchanged even though the world price is now higher. The license holder surplus increases to MNHJ.

So, even if the export quota system successfully raises the world price of coffee, it is the middle men who benefit, not the coffee farmers. Which is why, after the coffee export quota system collapsed in 1989, we would expect coffee farmers to have been made better off.

[Update: Fixed missing label in second diagram]

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